Lending Rate System in Indian Banking

The primary concern of financial institutions (FI) is to provide liquidity into the system and maintain the economic growth. One of the ways to accomplish this is by offering credit.All Institutions are there in the market to earn money while providing this facility and the major part of the income is the lending rate.

In Indian Banking system, lending rate is based on the MCLR (Marginal Cost of Funds Based Lending Rate) system. From April 2016 onwards Reserve Bank of India replaced the base rate system and introduced MCLR (Marginal Cost of Funds Based Lending Rate) system.

MCLR is an internal benchmark rate for the bank to decide the minimum interest rate for the loans on the basis of the marginal cost or the additional cost of arranging an extra rupee.

Why the MCLR reform?

RBI decided to shift from base rate to MCLR as the rates based on marginal cost of funds are more sensitive to changes in the policy rates. This is very vital for the effective implementation of monetary policy. Prior to MCLR system, different banks were following the different methodology for calculation of base rate or minimum rate – that was either on the basis of (1) average cost of funds or (2) marginal cost of funds or (3) blended cost of funds. Thus, MCLR aims:

To improve the transmission of policy rates into the lending rates of banks.

To bring transparency in the approach followed by banks for determining interest rates on advances.

To ensure availability of bank credit at interest rates which are rational to borrowers as well as banks.

Components of MCLR:

1. Cash Reserve Ratio – Banks have to keep some reserves with the RBI. It is the opportunity cost.

2. Operating Cost – It is the operating expenses incurred by the banks.

3. Marginal Cost of Funds – The marginal cost that is the innovative element of the MCLR. The Marginal Cost of Funds will consist of Return on Net worth and Marginal Cost of Borrowings. As per RBI, the Marginal Cost should be charged on the basis of following factors:

Interest rate is given for various types of deposits- savings, current, foreign currency deposit, and term deposit.

Borrowings – the Repo rate or Short-term interest rate or etc., Long term rupee borrowing rate.

Return on net worth – in accordance with capital adequacy norms.

MCLR is determined largely by the marginal cost for funds and particularly by the deposit rate and by the repo rate.

4. Tenor Premium – It is the additional slab of interest over the slab rate, based on the loan tenure & commitments.

How MCLR Works?

Suppose Axis Bank set a floating rate of home loan at one year MCLR of 9.20% with a spread of 0.25% for the loans up to Rs. 2 Crores. So, final rate of interest will be 9.45%, and it is valid till 31st Jan 2017. Bank has decided to set one-year MCLR as the benchmark rate for their home loans.

Though the MCLR is reviewed on monthly basis, your home loan will be reset every year automatically, depending on the agreement with the lending bank.

So, if you take Rs. 80 Lakhs home loan on 9th Jan 2017, your interest rate on the home loan would be 9.45%. You are supposed to pay EMI installments at this rate of interest for the next 12 months.

Let’s say 1-year MCLR is revised to 9% in April, 2017 and the spread is remaining for the same period then your home loan interest rate will be reset at 9.25%.

Effect of Demonetization on MCLR:

Since the government on 8 November banned Rs 500 and Rs 1, 000 currency notes, banks have received a large amount of deposits—Rs 14.97 trillion of deposits in old notes by 30th December 2016, approximately 90% of the demonetized currency has been deposited so far.

Source: www.tradingeconomics.com

State Bank of India (SBI) has made a deep 0.90% cut in its marginal cost of funds based lending rate (MCLR) across all maturities. Following this cut, home, personal, auto, and other loans will become cheaper. With this rate cut, the 1 year MCLR is at 8% against 8.9%. The new loans rates are effective from 1st January, 2017.

What we are seeing here is, therefore, a microeconomic variation, not a macro one. The banking system is just charging less for money in order to process more and more loans. Note that the repo rate hasn’t changed since October 2016. But instead of it being from the RBI side this rate is coming from an increase in the efficiency of the economy.

Welcoming 2017!

FI’s welcomed 2017 by reducing MCLR, it would definitely go to bring smiles on the faces of the masses by a reduction in the interest rates, majorly into the retail segment in near future.

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